“Upside-Down” Economy Takes a Bite out of Middle Class Wallets

The distribution of economic gains is upside-down in this recovery, compared to previous ones. Profits received a larger share of national income than wages. Hence, profits soared to record new highs amid the first job loss recovery since the Great Depression. Adding to families’ woes were rapidly rising costs; housing, education, and medical care jumped at double digit rates in recent years. To maintain consumption levels, many families borrowed more. However, this debt is now taking its toll. Families are being squeezed as they have to repay more and more debt, while the labor market is still trying to find its foothold. Many households lose this struggle and default on their loans, leading to serious ramifications for the economy.

Since November 2001, the U.S. economy has officially been in a recovery, during which the economy has seen a few firsts since World War II. This is the first time that two years into an economic recovery the labor market has fewer jobs than at the beginning of the recovery. Also, three years into the recovery, the economy has still not recovered all the jobs lost since the start of the recession – another first. At the same time, after tax profit rates have risen to record highs. For the first time in a recovery, the share of additional income that has gone to corporate profits is greater than the share that has gone to employee compensation – i.e. wages and benefits.

The historically unprecedented bifurcation of the economy – record profits amid the first job loss recovery – has meant that this recovery has depended more on borrowed money than any previous one has. Households increased their debt relative to income, aided by low interest rates and a booming housing market. By the end of 2003, household debt had reached a record high 116 percent of income, according to data from the Federal Reserve.

It is just a matter of time before the other shoe drops. Unless income rises significantly faster than it has, many more households will have to raise the white flag in the battle with their debt burdens. According to data from the Federal Reserve, the debt service burden – the share of income that households pay in interest and principal – has remained above 13 percent for nine consecutive quarters. That is the highest it has been since the Fed started keeping records in 1980. The debt service burden rose again in the fourth quarter of 2003. A broader measure – the financial obligation ratio, which includes rent payments and car leases – shows that households that rent their home have been paying more than 31 percent of their disposable income to meet their financial obligations for the past nine quarters. Again, this is higher than at any point in the previous 20 years.

Many households can no longer meet their financial obligations. Payments on over 3 percent of consumer loans, and on 4.5 percent of credit card debt,were more than six months late in the fourth quarter of 2003. And the share of credit card debt that was in default jumped to 6 percent in the fourth quarter of 2003, its highest level in a year and a half. In fact, for over three years, more than 5 percent of credit card debt has been in default – the highest level since the Federal Reserve started collecting this information in 1985. The default on some forms of credit is also mirrored by a rising trend in personal bankruptcies. According to American Bankruptcy Institute, a total of 1.6 million households, or 1.4 percent, declared bankruptcy in 2002, the last year for which data are available. Hence, the share of households that declared bankruptcy has quadrupled since 1980. Given the rise in debt and default rates, this trend likely continued in 2003.

The rise in debt and default can have serious economic ramifications. For one, households have less money to spend on consumption. And if households consume less, there is less of a reason for firms to invest and hire more workers. Also, as banks see the losses in their balance sheets mount, they may become more reluctant to grant new loans. However, loans are the grease in the wheels of an economy. Fewer loans means less investment and less growth.

Although the problems seem large, there are solutions. Remember that this is an upside-down economy. The important thing here is that companies have reached record high profit rates. Consequently, money is available. It just has not been invested in equipment and jobs. As the job market is showing signs of strengthening, policymakers should focus their energy on maintaining the momentum over the coming year. A strong job market will eliminate the pitfalls that arise from the hangover of the debt driven recovery of the past few years.